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When Insurers Go BustAn Economic Analysis of the Role and Design of Prudential Regulation
By Guillaume Plantin Jean-Charles Rochet
Princeton University PressCopyright © 2007 Princeton University Press
All right reserved.
The insurance industries of several countries have recently experienced periods of stress related to the failure of large, sometimes well-established, insurers. We begin our analysis with a study of four such cases: Independent Insurance and Equitable Life in the United Kingdom, Groupe desAssurances Nationales (GAN) and Europavie in France. These scandals have prompted a general and fierce debate (in the press, in the academic literature, but also in the political arena) about the need to reform the complex regulatory-supervisory systems that most countries have designed. The aim of this book is to offer practical recommendations, backed by rigorous economic analysis, for the reform of the prudential regulation of insurance companies.
Insurance companies are heavily regulated within virtually every country with a well-developed financial system. Moreover, insurance regulations endow public authorities with very significant control rights over insurers' strategic and financial decisions. This is even the case in countries where laissez faire economic policies are the order of the day. The regulator intervenes in the strategy andfinancial management of insurance companies via three channels:
tariff restrictions; entry and merger restrictions; prudential regulation (including insurance schemes that protect against company failures).
The first two types of intervention are rather common tools, used to regulate many other sectors, such as essential facilities. By contrast, prudential regulation is specific to financial institutions. Banks are, indeed, subject to prudential rules that are very similar to those applying to insurance companies. The rationale usually invoked for the prudential regulation of banks does not clearly apply to insurance companies, however. It is commonly asserted that banks have to be regulated because of their crucial role in issuing very liquid claims used as means of payment, namely deposits, while financing projects by means of illiquid loans. Thus banks are by nature illiquid and fragile, and subject to "runs." In addition, they finance each other via the interbank market, so that isolated runs may trigger systemic panics, likely to have important real effects on economic growth. Conversely, insurance firms are invested in more liquid and tradable assets that match their liabilities much better than bank loans match bank deposits. Moreover, the organization of the reinsurance market makes it less prone to contagion than the interbank market. Thus, firms seem less fragile, and contagion less likely. Insurance panics have not occurred, to our knowledge, in recent financial history.
So, what is special about insurance? Which achievements are out of range of free insurance markets? How could a prudential regulator do better than them? These are the main questions addressed in this book.
The book is organized as follows. Chapter 2 presents four case studies of insurance companies that went bust during the 1990s. We will draw lessons from these cases throughout the remainder of the book. Chapter 3 describes the practical organization of prudential supervision in the largest insurance markets. It also describes the risk-management tools that are most commonly used to analyze prudential supervision, and stresses what we view as the limits of these tools. Chapter 4 is our first application of modern corporate-finance theory to the insurance industry. We argue that because of the length and the inversion (this notion is explained in chapter 4) of the insurance production cycle, insurance firms are subject to severe agency problems that greatly amplify their operational risks. We show how capital requirements are an appropriate tool to discipline firms and contain these risks. Chapter 5 develops another application of corporate-finance theory to prudential regulation. We discuss the role of the allocation of control rights within firms, and the reasons why it may be desirable to grant such control rights to a supervisory authority in the case of financial institutions. Reconciling the evidence described in chapter 2 with the theory developed in chapters 4 and 5, chapter 6 develops our view of the optimal design of prudential regulation in the insurance industry, and offers concrete recommendations for the practical organization of supervision. Chapter 7 discusses the specifics of reinsurance-a crucial feature of the non-life insurance business. In chapter 8 we discuss the implications of our view of regulation for two fiercely debated issues: the supervision of financial conglomerates and the management of systemic risk. Chapter 9 concludes.
The reading of this book requires no particular prerequisites, neither in financial economics nor in insurance. Very simple models support some of our points. The important intuitions underlying them are always exposed in a nontechnical fashion.
Excerpted from When Insurers Go Bust by Guillaume Plantin Jean-Charles Rochet Copyright © 2007 by Princeton University Press . Excerpted by permission.
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Table of Contents
Chapter 1: Introduction 1
Chapter 2: Four Recent Cases of Financially Distressed Insurers 4
2.1 Independent Insurance Company Limited 4
2.2 Groupe des Assurances Nationales 13
2.3 Equitable Life 17
2.4 Europavie 25
2.5 Why Are Insurers Subject to Prudential Regulation? A First Pass 27
Chapter 3: The State of the Art in Prudential Regulation 29
3.1 The Main Features of Prudential Systems 29
3.2 Regulation and Ruin Theory: Controlling the
Probability of Failure 34
3.3 Conclusions 41
Chapter 4: Inversion of the Production Cycle and Capital Structure of Insurance Companies 43
4.1 Inversion of the Production Cycle in the Insurance Industry 43
4.2 An Analogy between Insurance Capital and Deductibles in Insurance Contracts 45
4.3 The Role of Deductibles in Insurance Contracts 47
4.4 The Role of Insurance Capital to Mitigate Informational Problems 50
4.5 Conclusion: The Inversion of the Production Cycle Creates Agency Problems That Can Be Mitigated by Capital Requirements for Insurance Companies 53
4.6 Appendix: Capital Requirements as an Incentive Device 54
Chapter 5: Absence of a Tough Claimholder in the Financial Structure of Insurance Companies and Incomplete Contracts 56
5.1 Absence of a Tough Claimholder 56
5.2 Prudential Regulation and Incomplete Contracts 59
5.3 The "Representation Hypothesis" 61
Chapter 6: How to Organize the Regulation of Insurance Companies 64
6.1 Simple Prudential Ratios 64
6.2 "Double Trigger" 66
6.3 An Independent but Accountable Prudential Authority 68
6.4 Granting Control Rights to the Industry via a Guarantee Fund 69
6.5 A Single Accounting Standard 71
6.6 Limiting the Scope of Prudential Regulation 72
6.7 What if This Is Not Enough? 73
Chapter 7: The Role of Reinsurance 75
7.1 Organization of the Reinsurance Market 75
7.2 Reinsurance and Prudential Supervision 81
Chapter 8: How Does Insurance Regulation Fit within Other Financial Regulations? 83
8.1 Insurance and Financial Conglomerates 83
8.2 The Regulation of Banks and of Insurance
Companies Are Two Different Jobs 90
8.3 Insurance and Systemic Risk 93
Chapter 9: Conclusion: Prudential Regulation as a Substitute for Corporate Governance 97
What People are Saying About This
This book provides a rare economic analysis of the regulation of the insurance industry from two authoritative authors. The book is timely and well researched, and it brings together the current state of the art in economic analysis with a thorough understanding of the institutions. It will become essential reading for anyone interested in this important policy area.
Hyun Song Shin, Princeton University
"This is an important contribution because it goes beyond and strongly criticizes the literature and preconceptions of the regulatory and insurance industries. Beyond readers in the specific field, it will be useful to readers interested in regulation more generally and to readers in finance and banking. I have seen no other book like this. It is most welcome."Philip Booth, Cass Business School, London
This is an important contribution because it goes beyond and strongly criticizes the literature and preconceptions of the regulatory and insurance industries. Beyond readers in the specific field, it will be useful to readers interested in regulation more generally and to readers in finance and banking. I have seen no other book like this. It is most welcome.
Philip Booth, Cass Business School, London